Picking Munis in a Roiled Market

By

Randall W. Forsyth

Updated May 7, 2011 12:01 a.m. ET

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When Barron's assembled a Roundtable on municipal bonds, four veteran portfolio managers were in attendance, but there was another, almost palpable, presence in the room: Meredith Whitney. Even though it's been months since she made her now-famous (or infamous) prediction of "50 to 100 sizable defaults" by muni-bond issuers totaling "hundreds of billions" of dollars in 2011 to a credulous 60 Minutes correspondent, and defaults have totaled a tiny fraction of a percent of that prediction, that forecast still hangs over the market. Money has flowed steadily out of tax-exempt bond funds, albeit more slowly recently, even as the muni market has recovered from its late-2010, early-2011 swoon.

But, as James Tracy, chairman of the Money Management Institute, a trade group representing asset managers, notes, the muni holdings of its members' clients slipped only slightly as a percentage of assets, to 14.6% at the low from 15.8% at the high.

Two things haven't changed: State and local finances remain under extraordinary stress, and some munis look extremely attractive, relative to other debt securities. Munis, which offer tax-free interest, often yield more than comparably rated taxable corporate or foreign-government bonds.

To sort through this idiosyncratic sector of the credit market, four leading muni managers recently gathered at Barron's Manhattan office: Daniel S. Solender of Lord Abbett, John V. Miller of Nuveen Asset Management, Peter J. Hayes of BlackRock and James Evans of Eaton Vance Management. Highlights of our morning-long conversation follow.

Barron's:Meredith Whitney stirred up a hornet's nest with her prediction, which she reiterated recently. It's safe to say you gentlemen disagree.

Solender: Well, when she made those comments, we were going through a stretch where interest rates had been going up for a while, so our funds were down. So, she spoke, and people saw the values of their investments going down. The outflows [from muni funds] started around Veterans Day…

Before the 60 Minutes piece…

Solender: Then the elections came, tax rates weren't going to go up, though the Build America Bond program was going to disappear. So a lot of things were happening. People put all these things together and thought she was correct.

Miller: It was very one-sided. It does conflict with the facts of what is happening on the fundamental credit front. But the outflows, which were unprecedented in magnitude, created self-fulfilling prophecies. The selling caused net asset values to drop, and that caused more outflows.

Hayes: I think she said what probably many of us in this room have said and much of the industry has said: States have problems. The problem was the 50 to 100 defaults totaling billions of dollars that was the sensational headline. That number was somewhat pulled out of the air.

Did the muni market's structure figure in the selloff?

Evans: That's a really important point. Muni bonds are really the only securitized asset class dominated by individuals. Individuals own 70% to 75% of all munis, including those held through proxies, such as bond funds. If they want to put more money in or take money out, they can really move the market. In most other asset classes, only pension and other institutional managers can do that.

Hayes: It's interesting when you take Jim's comments and you look at what the Build America Bonds did. [Build America bonds were taxable municipal bonds that received a 35% federal interest-rate subsidy.] That program opened up the asset class, in taxable form, to a much broader set of investors. When it ended at the end of 2010, that added to [the market's problems.]

Solender: One of the things leading up to last fall was that we had record flows into municipal-bond funds in 2009 and the first nine months of 2010. A lot of people coming into the muni market probably hadn't invested in it in the past. All of a sudden, things started getting negative for them.

Hayes:You have seen more people recently buy individual bonds and move out of mutual funds. I think the funds that use a sophisticated financial intermediary probably have seen less outflows, perhaps, than funds that don't.

The fact remains that a lot of state and local governments are in fiscal distress. What will happen?

Solender: By law, 49 of the 50 states must balance their budgets; only Vermont doesn't and it does anyway. We've had several straight quarters in which revenues have been up on the state level. They're not back to where they were in 2008, but they've really been coming back at a pretty good pace. And the next level is the local governments.

That's seems to be where the real crunch will come, because the states can pass the burden down to counties and school districts.

Solender: The local governments have been, until recently, doing fine, because their taxes were based on real-estate values, which lag in terms of assessed valuations. They have just started seeing their revenue tick down. The way they will make it, going forward, is to cut a ton of services.

Has there been any market impact from the effort in states to curtail public employees' collective bargaining?

Solender: Not much. In some of the bigger states, like California, bonds move based on news. One of the things we deal with in our market is politics. It is a challenge at all times to deal with politicians. New Jersey, where I live, always has a lot of headline risk.

Miller: On the state side, we're somewhat encouraged by the revenue increases. And the expenditure side has been cut over the past 12 months or so. State and local government employment is down about 280,000. California and Illinois, between now and June 30, probably will be the market's biggest drivers, because they still have big budget gaps to close.

John, what's your home-state view of Illinois, which enacted a rather large income-tax increase?

Miller: This situation has really been built up over 10 to 20 years, and some of the kicking the can down the road has been exposed by the recent economic weakness. So, when Illinois raises taxes from 3% to 5%, revenue will probably rise from about $50 billion to $60 billion in a one-year period. Their interest expense annually is about $1 billion; with principal, their overall debt service is about $2 billion. Debt service is growing. They have past- due bills. They have an underfunded pension system. But they are taking some steps to correct the situation.

Peter, what's your view?

Hayes: About 50% of the states' revenues, on average, are derived from personal income taxes and sales taxes. The economy is improving, so revenues are improving. In the meantime, the states are cutting spending, plus they have a lot of other tools to balance their budget.

But the bernefits for states and localities from the $787 billion federal stimulus ends on June 30.

Solender: As we move toward an election year, the answer on the state level is going to be cutting jobs, cutting services. But can you get re-elected by cutting services for people?

Evans:In the past three years, states had about $230 billion in budget gaps, which they closed through spending cuts and tax increases. The state and local gaps, combined, came to $430 billion; that's a substantial number, which they did close. And now they are cutting more expenses and raising additional revenue. The bigger issue is the unfunded pension and health-care obligations.

What do you see there? Can they change what they owe to someone who is already in the system?

Evans: Twenty states have already lowered their pension obligations. A lot of this is going to be tested in court. I really don't know how it is going to come out. But for the most part, health-care obligations or OPEB—other post employment benefits, as they call it—can be reduced or eliminated without any real issue. They aren't on the same level as debt service or pensions. Pensions, for the most part, although not in all states, are pari passu [of equal priority] with debt.

Hayes: The important thing is that there finally is a realization that something must be done. The good news: It is a long-term liability. If you increase the retirement age, for instance, by 10 years, that reduces the liability. If you simply raise taxes—but obviously, that is very difficult to do—that also can eat away at the liability.

John, is this really affecting municipal credits?

Miller: No. But we are getting closer and closer to the point where, if they don't take action, you may see an effect on valuations of bonds from states with particularly large unfunded liabilities.

Solender: The key thing is that not every state has a pension problem. There are just a couple. New Jersey and Illinois, being the big ones.

Those big ones comprise a big part of the aggregate problem. But I'd like to switch gears here. How is the overall economic outlook affecting munis?

Evans: The economy isn't going gangbusters, but is doing pretty well. And if the economy is improving, it helps municipal credit quality. General-obligation bonds are what everyone talks about, but that's only about a quarter of our issuance. The other three-quarters are revenue bonds. Those types of bonds are helped by the economy. A lot of them are essential services; regardless of how the economy is doing, people have to pay a water and sewer utility. A lot of people are predicting that interest rates are going up. It isn't happening now, but at some point, it probably will. But if interest rates do go up, municipal bonds only get back to more historical levels versus Treasuries and other markets.

In other words, muni yields already are up and other sectors will catch up. John, what's your view?

Miller: Our firm is projecting an economic slowdown over the balance of the year, even though we feel the expansion will continue, with GDP growth in the 2%-2½% range. The slowdown factors include federal fiscal stimulus declining and less impactful negotiations on cutting the federal deficit. And I'd reiterate that munis have priced in the significant increase in interest rates most people anticipate.

Peter, do you agree?

Hayes: We still think that the economy is on a positive track, but at a fairly slow pace, probably with gross domestic product growth at 2½%-3%, for many of the reasons John mentioned. State and local government layoffs alone may subtract as much as one-half of a percentage point to one point from GDP, but that won't be realized until perhaps the third or fourth quarter. We aren't worried about severely higher interest rates hitting the long end of the yield curve. We are cautious on the Fed, what the Fed will do and what that will do to the shape of the yield curve—probably flatten it over time.

John?

Miller: My personal view is that you see excess capacity everywhere, which hurts housing and employment. So, rates will remain low in a relatively low-inflation environment. People are very concerned about commodity inflation. But from January 2002 to mid-2008, the Rogers International Commodity Index was up about 350%—26% annualized. Yet, the consumer-price index rose only 3% annualized.

Dan, where do you see value?

Solender:In the 20-to-25-year range, where you can get over 5% yields for double-A bonds.

What do you garner from single-A and triple-B credits?

Solender: Over 6% for single-As, and you can get over 7% for lower quality. We also like a lot of private-university issues. The population of college-age children is at the peak right now.

What about you, John?

Miller: Look at Los Angeles Department of Water & Power or University of Southern California bonds. I don't think there is a strong reason that the budgetary issues of California should make those bonds substantially cheaper.

But they have. What kind of yields do they offer?

Miller: In the neighborhood of 5% for 20-to-25 year bonds. But even within double-A bonds, health care versus water and power or water and sewer, there is a significant credit spread.

Health care is higher. Why?

Miller: Health-care reform, issuance patterns, plus health-care bonds never had the benefit of the Build America program. One name I like is Sutter Health Care. It's been a major issuer over the past several years in Northern California. It's a double-A rated multiple hospital system; it would be yielding 5.9%. Similar things go on in Illinois, where Northwestern Universityis a natural triple-A credit. It's a private institution with a large endowment and good reputation.

Peter, where do you see opportunities?

Hayes:We think there is value out on the yield curve. Going from a two-year maturity to a 30-year maturity in the triple-A space, you now pick up over 400 basis points [four percentage points]. Historically, the average has been around 225 basis points. In terms of sectors, there's value in revenue bonds in the single-A range. Chicago issued a deal for O'Hare International Airport, and it was oversubscribed four or five times.

That also speaks to the paucity of new-issue supply. What was the yield?

Hayes:The longer-term O'Hare bonds were priced closer to 6% out to 25 to 30 years. We also like hospitals. We prefer multi-state systems like Ascension Health[the largest nonprofit health-care system in the U.S.] We also like toll roads, but established ones. If you travel the New Jersey Turnpike on a Sunday afternoon, you see a lot of tolls being paid. Harris County Toll Road Authorityin the Houston area is another name.

Texas yields tend to be high because the state has no income tax. Are Texas bonds attractive for out-of-state buyers?

Hayes: Yes. On a relative basis, Texas bonds are inexpensive. And it has a big concentration in energy and other natural resources, so its economy has done quite well.

Miller: Florida is interesting, too. I consider it to have a well-run state government. It has a balanced budget, and its pension fund has one of the best funding ratios in the country. But because it eliminated its intangibles tax, there was less incentive to hold Florida munis, and then the state was hit hard by the real-estate crisis. Florida has lots of attractive muni bonds, including revenue bonds from Miami International Airport.

Jim, what opportunities you see?

Evans: One thing we focus on is finding places with low unfunded pension and health-care obligations. Virginia, Texas, North Carolina, Florida all have very low unfunded pension obligations. On the flip side, while we are concerned about Illinois, California and New Jersey, just because a state has issues doesn't mean that every bond within it is a problem. GOs such as those issued by Lake County, north of Chicago, will be in fine shape, even if the state runs into problems. One of the fun things about the muni market is that it is very inefficient. There are just so many issuers that it is tough for people to get their arms around them all. State of Illinois bonds are probably trading around 190 basis points [1.9 percentage points] over triple-A's now. But California is probably 90 over, and New Jersey is probably 80 over.

One thing I would be concerned about in California is that its municipalities could get hurt badly because the state budget cuts are so severe. It is very difficult for the localities there to raise revenue. You can't do it through property tax, which is where most localities get a lot of their money. You can't raise the income tax. The state sales tax is already the country's highest.

And on the list of non-state pensions with big unfunded liabilities, 20 of the 50 names are in California.

Can you give other examples?

Evans: Outside that state, Chicago is No. 1 with an unfunded liability that we've calculated at $36,000 per household in the city, followed by New York City, $34,000; San Francisco, $30,000; and Boston, $27,000.

Dan, what would you avoid?

Solender: There was a lot of issuance before the [2008-2009] credit crisis. Some projects were pushed into the market late in the cycle. Whether it was real estate not being sold or a senior living facility not being filled up, those are projects you have to be careful with. It will take real improvement in the economy for them to get to where they were supposed to be. Generally speaking, these are projects dating from late 2006 through 2007.

Speaking of trouble, what about Detroit?

Solender: With munis there's never a straight answer. Detroit has straight general-obligation bonds, and then there are all kinds of bonds that bear its name, but aren't Detroit GOs. They are bonds that are backed by Michigan in the sense that the state helps fund them—Detroit sewer bonds or Detroit water bonds, which could be really good buys. For Detroit GOs themselves, it's very hard to do serious analysis; it is so political.

Michigan has a much higher quality redit, a much more diverse set of revenue. There are a lot of good areas in Michigan. At the right price, there is a reason to buy bonds backed by Michigan or programs that the state provides.

Thanks. To economize space, we'll summarize your other picks in a table.

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